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The Independent Online
There is no greater competition between investment practitioners than that between those who favour growth shares and those who engage in so-called "value" investing. The former say that the key to making money consistently is buying shares that are experiencing rapid growth in earnings. The latter say that a much better approach is to look for those that are selling at such a low price - relative to earnings, asset value or cash flow - that the only way they can go is up.

These two approaches stand at the twin ends of the investment spectrum. Most investors incline, by choice or by temperament, to one approach or to the other. Both like to call on important figures in the history of investment theory. Value investors, for example, pay allegiance to Ben Graham, an American academic turned investment manager.

Graham was a classical scholar who liked nothing better than reading the small print in balance sheets. He was the first man to turn stock market research into a reputable activity, and in a series of books and monographs laid down a series of guidelines for value-based investing which are still required reading for serious students. His book, Security Analysis, remains the standard textbook for professional analysts and fund managers.

Growth stock investors, by contrast, pay homage to a different pantheon of heroes. Perhaps the first to establish a lasting reputation for his methods was another American, T Rowe Price. His name still adorns a number of mutual funds in the United States. In more recent times, and in this country, Jim Slater is one well-known investor who has popularised his own version of growth stock theory.

Given the millions of words that have been expended by proponents of these two schools of investing to prove the superiority of their chosen methods, anyone who tries to summarise the differences in a few lines is liable to be accused of distortion and simplification. The divisions are not perhaps quite as deep as those between Eurosceptics and Europhiles, but they are not far behind.

Crudely summarised, however, the kind of shares that get growth stock investors excited are small, fast growing companies whose earnings rise steadily over a period of years. By definition, they tend to have low dividend yields - growth stocks are too busy growing to have much time for dividends - and high price/earnings ratios. Most of their value is represented by future potential, rather than past achievement or current performance. Investors who can find and jump aboard such a company while it is still on its growth trajectory can often make spectacular returns.

What excites a value investor, by contrast, are shares that, for whatever reason, are selling at what looks like a cheap price, when compared with their own recent performance or that of the rest of the stock market. A good stock for a value investor is one with a high yield and low price/earnings ratio. Best of all is a company that has plenty of assets but which is currently out of favour with the prevailing fashion in the stock market. Those who have the courage to buy this kind of share at the height of its unpopularity can also make a lot of money.

Which strategy is better? The arguments have raged for years. In practice, a lot depends on two things: Firstly, what sort of risks the investor is looking to take. Growth stocks may be potentially the most rewarding, but they also carry a higher risk of failure - and you also have to be able to spot the real growth stocks from the shooting stars, companies that fizzle strongly, only to burn out equally quickly. Value investors by contrast tend to be much more risk-averse.

Secondly, what is happening to the market and the economy as a whole. The early stages of an upturn in the economic cycle tend to produce a raft of small companies whose products or services are much in demand, and whose earnings are therefore growing fast. The question is whether they can sustain that growth when the cycle turns down, or when the market itself moves from a bear to a bull phase. The best time to find value stocks is when gloom in both the stock market and the economy is all around - as it was in the mid 1970s. Then you can buy blue chip companies on earnings or asset value multiples that are but a fraction of their historical average. In markets like today's, when optimism is high and interest rates have fallen sharply, that is less easy.

A research study in the United States now claims to have new and definitive insights into the timeless debate between value and growth investors. According to the Wall Street weekly magazine, Barron's, a fund manager called Jim O'Shaughnessy has gained exclusive access to the vast Standard & Poor's database of stock market performance in the 45 years since 1951. He has used it to test which stock-picking strategies have produced the best results over that period.

The full results will not be published until the summer, but these are some of his conclusions, as reported by Barron's. In general, they tend to support the view that value investing is the better bet over the long term, but with some notable exceptions. Bear in mind that the data refers exclusively to Wall Street, though the results in London would almost certainly be little different:

Popular stocks are a surefire way to lose money. If you had bought those shares with the highest prices relative to cash flow, sales or assets, you would have seriously underperformed the stock market as a whole in subsequent years.

Buying shares based solely on their price/earnings ratio is also a good way to underperform the market as a whole. Shares that have either unusually high or unusually low p/e ratios provide no guarantee of exceptional performance; if anything, rather the opposite.

What does seem to work well is buying the shares that have done best in the previous year. Among big companies, those that were the worst performers in the previous year continue to underperform as a group. In general, says Mr O'Shaughnessy, all the best stock-picking strategies he found were based, in part at least, on finding shares which displayed strong relative strength (ie, they had done better than the market as a whole in the recent past).

The best results of all seem to come from combining value and growth criteria - for example, picking those shares with above average recent performance whose market value was also low relative to the company's sales. The main drawback: finding companies that meet these criteria is often hard to do.

The other drawback with such historical analyses is that - as it rightly says in the small print of all financial advertisements these days - past performance is no guide to future performance. What Mr O'Shaughnessy's research does underline, however, is that following fashion is one certain way to secure disappointment.

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